The potential of an advertising tax

Jan 7, JDN 2458126

Advertising is everywhere in our society. You may see some on this very page (though if I hit my next Patreon target I’m going to pay to get rid of those). Ad-blockers can help when you’re on the Web, and premium channels like HBO will save you from ads when watching TV, but what are you supposed to do about ads on billboards as you drive down the highway, ads on buses as you walk down the street, ads on the walls of the subway train?

And Banksy isn’t entirely wrong; this stuff can be quite damaging. Based on decades of research, the American Psychological Association has issued official statements condemning the use of advertising to children for its harmful psychological effects. Medical research has shown that advertisements for food can cause overeating—and thus, the correlated rise of advertising and obesity may be no coincidence.

Worst of all, political advertising distorts our view of the world. Though we may not be able to blame advertising per se for Trump; most of his publicity was gained for free by irresponsible media coverage.

And yet, advertising is almost pure rent-seeking. It costs resources, but it doesn’t produce anything. In most cases it doesn’t even raise awareness about something or find new customers. The primary goal of most advertising is to get you to choose that brand instead of a different brand. A secondary goal (especially for food ads) is to increase your overall consumption of that good, but since the means employed typically involve psychological manipulation, this increase in consumption is probably harmful to social welfare.

A general principle of economics that has almost universal consensus is the Pigou Principle: If you want less of something, you should put a tax on it. So, what would happen if we put a tax on advertising?

The amazing thing is that in this case, we would probably not actually reduce advertising spending, but we would reduce advertising, which is what we actually care about. Moreover, we would be able to raise an enormous amount of revenue with zero social cost. Like the other big Pigovian tax (the carbon tax), this a rare example of a tax that will give you a huge amount of revenue while actually yielding a benefit to society.

This is far from obvious, so I think it is worth explaining where it comes from.

The key point is that advertising doesn’t typically increase the overall size of the market (though in some cases it does; I’ll get back to that in a moment). Rather that a conventional production function like we would have for most types of expenditure, advertising is better modeled by what is called a contest function (something that our own Stergios Skaperdas at UCI is actually a world-class expert in). In a production function, inputs increase the total amount of output. But in a contest function, inputs only redistribute output from one place to another. Contest functions thus provide a good model of rent-seeking, which is what most advertising is.

Suppose there’s a total market M for some good, where M is the total profits that can be gained from capturing that entire market.
Then, to keep it simple, let’s suppose there are only two major firms in the market, a duopoly like Coke and Pepsi or Boeing and Airbus.

Let’s say Coke decides to spend an amount x on advertising, and Pepsi decides to spend an amount y.

For now, let’s assume that total beverage consumption won’t change; so the total profits to be had from the market are always M.

What advertising does is it changes the share of that market which each firm will get. Specifically, let’s use the simplest model, where the share of the market is equal to the share of advertising spending.

Then the net profit for Coke is the following:

The share they get, x/(x+y), times the size of the whole market, M, minus the advertising spending x.

max M*x/(x+y) – x

We can maximize this with the usual first-order condition:

y/(x+y)^2 M – 1 = 0

(x+y)^2 = My

Since the game is symmetric, in a Nash equilibrium, Pepsi will use the same reasoning:

(x+y)^2 = Mx

Thus we have:

x = y

(2x)^2 = Mx

x = M/4

In this very simple model, each firm will spend one-fourth of the market’s value, and the total advertising spending will be equal to half the size of the market. Then, each company’s net income will be equal to its advertising spending. This is a pretty good estimate for Coca-Cola in real life, which spends about $3.3 billion on advertising and receives about $2.8 billion in net income each year.

What would happen if we introduce a tax? Let’s say we introduce a proportional tax r on all advertising spending. That is, for every dollar you spend on advertising, you must pay the government $r in tax. The really remarkable thing is that companies who advertise shouldn’t care what we make the tax; the only ones who will care are the advertising companies themselves.

If Coke pays x, the actual amount of advertising they receive is x – r x = x(1-r).

Likewise, Pepsi’s actual advertising received is y(1-r).

But notice that the share of total advertising spending is completely unchanged!

(x(1-r))/(x(1-r) + y(1-r)) = x/(x+y)

Since the payoff for Coke only depends on how much Coke spends and what market share they get, it is also unchanged. Since the same is true for Pepsi, nothing will change in how the two companies behave. They will spend the same amount on advertising, and they will receive the same amount of net income when all is said and done.

The total quantity of advertising will be reduced, from x+y to (x+y)(1-r). That means fewer billboards, fewer posters in subway stations, fewer TV commercials. That will hurt advertising companies, but benefit everyone else.

How much revenue will we get for the government? r x + r y = r(x+y).

Since the goal is to substantially reduce advertising output, and it won’t distort other industries in any way, we should set this tax quite high. A reasonable value for r would be 50%. We might even want to consider something as high as 90%; but for now let’s look at what 50% would do.

Total advertising spending in the US is over $200 billion per year. Since an advertising tax would not change total advertising spending, we can expect that a tax rate of 50% would simply capture 50% of this spending as revenue, which is to say $100 billion per year. That would be enough to pay for the entire Federal education budget, or the foreign aid and environment budgets combined.
Another great aspect of how an advertising tax is actually better than a carbon tax is that countries will want to compete to have the highest advertising taxes. If say Canada imposes a carbon tax but the US doesn’t, industries will move production to the US where it is cheaper, which hurts Canada. Yet the total amount of pollution will remain about the same, and Canada will be just as affected by climate change as they would have been anyway. So we need to coordinate across countries so that the carbon taxes are all the same (or at least close), to prevent industries from moving around; and each country has an incentive to cheat by imposing a lower carbon tax.

But advertising taxes aren’t like that. If Canada imposes an advertising tax and the US doesn’t, companies won’t shift production to the US; they will shift advertising to the US. And having your country suddenly flooded with advertisements is bad. That provides a strong incentive for you to impose your own equal or even higher advertising tax to stem the tide. And pretty soon, everyone will have imposed an advertising tax at the same rate.

Of course, in all the above I’ve assumed a pure contest function, meaning that advertisements are completely unproductive. What if they are at least a little bit productive? Then we wouldn’t want to set the tax too high, but the basic conclusions would be unchanged.

Suppose, for instance, that the advertising spending adds half its value to the value of the market. This is a pretty high estimate of the benefits of advertising.

Under this assumption, in place of M we have M+(x+y)/2. Everything else is unchanged.

We can maximize as before:

max (M+(x+y)/2)*x/(x+y) – x

The math is a bit trickier, but we can still solve by a first-order condition, which simplifies to:

(x+y)^2 = 2My

By the same symmetry reasoning as before:

(2x)^2 = 2Mx

x = M/2

Now, total advertising spending would equal the size of the market without advertising, and net income for each firm after advertising would be:

2M(1/2) – M/2 = M/2

That is, advertising spending would equal net income, as before. (A surprisingly robust result!)

What if we imposed a tax? Now the algebra gets even nastier:

max (M+(x+y)(1-r)/2)*x/(x+y) – x

But the ultimate outcome is still quite similar:

(1+r)(x+y)^2 = 2My

(1+r)(2x)^2 = 2Mx

x = M/2*1/(1+r)

Advertising spending will be reduced by a factor of 1/(1+r). Even if r is 50%, that still means we’ll have 2/3 of the advertising spending we had before.

Total tax revenue will then be M*r/(1+r), which for r of 50% would be M/3.

Total advertising will be M(1-r)/(1+r), which would be M/3. So we managed to reduce advertising by 2/3, while reducing advertising spending by only 1/3. Then we would receive half of that spending as revenue. Thus, instead of getting $100 billion per year, we would get $67 billion, which is still just about enough to pay for food stamps.

What’s the downside of this tax? Unlike most taxes, there really isn’t one. Yes, it would hurt advertising companies, which I suppose counts as a downside. But that was mostly waste anyway; anyone employed in advertising would be better employed almost anywhere else. Millions of minds are being wasted coming up with better ways to sell Viagra instead of better treatments for cancer. Any unemployment introduced by an advertising tax would be temporary and easily rectified by monetary policy, and most of it would hit highly educated white-collar professionals who have high incomes to begin with and can more easily find jobs when displaced.

The real question is why we aren’t doing this already. And that, I suppose, has to come down to politics.